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Chair Yellen Should See Advantages in Monetary Policy Rules

Economics Finance

In semiannual testimony before Congress, Federal Reserve Chair Janet Yellen alluded to the challenges the Federal Open Market Committee would face if, as required by the 2017 Financial CHOICE Act, it adopted a specific rule to guide monetary policy decisions.  The Monetary Policy Report accompanying her presentation describes these challenges in greater detail.  Upon reflection, however, some of these challenges highlight more clearly the advantages of a rule-based approach to monetary policymaking.

On page 4 of her remarks, Chair Yellen warns that simple policy rules should never “be applied in a mechanical way.”  This is quite true.  But, it is also true that the CHOICE Act does not require the Fed to apply its chosen rule in a purely mechanical way.  The FOMC always can depart from the prescriptions of that rule, provided it explains why.  This first point, therefore, cannot be read as an argument against the CHOICE Act.

Page 39 of the Monetary Policy Report describes a more serious challenge to the use of simple monetary policy rules.  Different rules will, at any given time, prescribe different settings for the federal funds rate, and there is no way of knowing, in advance, which of these settings is consistent with the most favorable economic outcomes.  The Report makes this point vividly by comparing in one graph the implications of five equally sensible rules that, for the first quarter of 2017, prescribe settings for the funds rate ranging from 0.37 to 2.5 percent!

As we argued in a previous column, it is probably a bad idea to turn the Fed Chair’s reports to Congress into live debates over the relative merits of different policy rules.  For this reason, the CHOICE Act’s authors may wish to drop from their proposed legislation the requirement that the FOMC compare its settings for the funds rate to those prescribed not only by the “directive rule” of its own choosing but also a “reference rule” dictated by law.

Suppose for the sake of argument, however, that the FOMC announced, as its single rule, the one that currently prescribes the highest, 2.5 percent, setting for the funds rate.  This rule, which the Report describes as taking a “balanced approach” to stabilizing inflation and unemployment, has the form

f  = r* + p + (1/2)(pp*) + 2(u*­u),

where f is the federal funds rate, r* the long-run real interest rate, p the rate of inflation, p* the Fed’s inflation target, and u* and u the natural and actual rates of unemployment.  One reason why this balanced rule dictates a large increase in the funds rate is that the unemployment rate, now at 4.4 percent, has fallen so low.  Most observers would agree, however, that this very low unemployment rate overstates the true strength of the American labor market and the economy as a whole.  Under these circumstances, it would be easy for the Fed Chair to explain that while the balanced rule offers support for further rate hikes, it remains prudent to keep the funds rate below the level prescribed by the rule pending a noticeable pick-up in prices and wages.  Even when departing from their simple rule, therefore, policymakers could use that rule to explain what they are doing and why.

Page 38 of the Monetary Policy Report criticizes simple policy rules for ignoring risks to financial stability. This is true, but “financial stability,” unlike “stable prices” and “maximum employment,” is not part of the Fed’s formal mandate expressed in the Full Employment and Balanced Growth Act.  Nonetheless, a policy rule would not prevent the Fed from responding to an episode of severe financial stress, such as the crisis of 2007-08.  Instead, as in the case above, it should be easy for the Fed Chair to explain why the FOMC is deviating from its chosen policy rule.

During normal times, however, it’s far less clear the Fed should react to asset price movements.  After all, long-term bond and equity prices should fluctuate, in order to provide households and firms with valuable information they need to make efficient saving and investment decisions.  Curiously, however, a recent paper by Duke University scholar Anna Cieslak and University of California (Berkeley) scholar Annette Vissing-Jorgensen suggests that the FOMC often has made policy decisions in response to stock price movements with, presumably, less commitment to its official mandate.  A simple rule that excludes financial variables would constrain the Fed from reacting to asset prices while still allowing the FOMC to take actions during extraordinary times – so long as it explains what it is doing and why.

Chair Yellen is right: simple monetary policy rules never should be followed mechanically.  But, by adopting and making consistent reference to one such rule in accordance with the CHOICE Act, she and her FOMC colleagues could communicate their actions and intentions more clearly and effectively to Congress and the public.

Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market CommitteeMichael Belongia is a professor of economics at the University of Mississippi.

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